The mechanics of Cryptocurrency: Why the future of finance is digital?
From the primitive barter systems of the early times to today’s web-based transactions and cryptocurrency, the global financial system has undergone a drastic evolution to reach its contemporary state. At the heart of it all, may it be the exchange of commodities as barter or the exchange of paper or digital currency for acquiring goods and services, lies the concept of value.
Asset vs Currency
Value stands as the principle distinguishing feature between Asset and currency. Standard currencies, be digital numbers or physical bank notes, derive value from the trust placed in the governments or issuing entities that are backing them.
Particularly after the abandonment of the gold standard, these currencies are essentially IOUs issued by governments with no intrinsic value that can be printed on demand and their values manipulated as wished, which sets them apart from assets with intrinsic and tangible value.
Value as a function of supply: Precious metals such as gold and silver, given their limited supply in nature or scarcity, have been used as assets throughout history, serving essentially as a means for exchanging services and products. An artificial supply of these metals cannot be created, giving them an intrinsic value that allows them to be exchanged, used as a store of value, and traded across the world, making them highly reliable.
Devaluation: In stark contrast, currencies lack reliability due to their unlimited supply, which governments and controlling entities can manipulate and regulate. These features devoid currencies of the ability to be used as a dependable store of value. Excessive currency printing can even cause currency values to drop, resulting in inflation. Zimbabwe’s hyperinflation stands as a case in point where printing vast amounts of currency and other monetary malpractices have sent inflation rates through the roof, rendering the country’s currency worthless.
In essence, banknotes and currencies backed by governments are not dependable means to store value and cannot be termed as assets as opposed to gold, silver, and other assets with intrinsic exchange values.
Centralized vs decentralized
Traditional state-backed currencies are centralized, with central banks and governments exercising control over their printing and flow. A controlling authority also acts as a medium when transferring these currencies over long distances and between accounts while charging a fee for the process. The possessors of these currencies have to put their trust in the states and banks backing the currencies to play fair and honor their commitments. On the contrary, cryptocurrencies are decentralized currencies with no controlling entities manipulating their values and flow. The value of these currencies is instead controlled exclusively by market forces, which does not require putting your trust in governments and banks.
What’s a Fiat currency
Another idea essential to understanding the significance of cryptocurrency is the concept of fiat currencies. Commodity currencies issued by governments in the past guaranteed their possessors a right to exchange them for gold or silver of the same amount. Fiat currencies, on the other hand, do not provide possessors with any such option since currencies today are not backed by any assets; instead, they get their value from a trust placed on the issuing government or authority. This could result in the currency losing value due to excessive printing or a drop in confidence over the issuer's ability to pay back what it owes. Corrupt and incompetent governments implementing poor policies can also negatively impact the value of these currencies, resulting in the holders taking losses.
Digital vs Physical
Not too long ago, physical currencies were the only options available to people for carrying out their transactions and exchanges in the market. Given that people have relied on these instruments for centuries to perform their financial activities, it is only understandable that the acceptance of digital currencies had initially faced an opposing inertia, slowing down the adoption pace. Looking at the long history of physical currency use, people had started associating physical forms of currency with security and dependability. This has slowly but gradually changed with the increasing acceptance of digital currencies, including cryptocurrencies.
The Crypto Effect and Blockchain
Cryptocurrencies today are gaining popularity since, with them, transactions can be completed securely and at a rapid pace, without the need for any intermediaries, making them the favorable option as opposed to physical currencies. Furthermore, having characteristics similar to gold, such as a limited supply, a value that cannot be manipulated, and being decentralized, has caused many to dub Bitcoin the “digital gold” of tomorrow.
Blockchain
Purpose:
Blockchain technology serving as the foundation for cryptocurrencies is the base on which the whole cryptocurrency infrastructure is built. The blockchain serves as a ledger for cryptocurrencies, which holds transaction information, including the transaction amounts and the wallet addresses of the receiver and the sender.
Architecture:
The blockchain architecture consists of multiple blocks, with each containing information on the previous and next block addresses. This ensures data security and prevents tampering. The first block called the Genesis block, has no previous addresses, and subsequent blocks are added as unalterable hashes. These hashes are created using advanced cryptography and can be verified through a consensus mechanism involving millions of computers. This mechanism ensures the accuracy and trustworthiness of the data.
Unlike traditional architectures, blockchain technology allows validators or nodes to act as peers, creating a network where everyone is a server and client. This makes the technology versatile and accessible to everyone. Blockchain technology does not require hosting and exists without a central server, similar to the Internet. The processing power of blockchain technology is used to create unique keys, ensuring secure transactions and data storage.
As with any new technology, cryptocurrency comes with its own batch of skeptics questioning its efficacy, environmental impact, and overall significance. Though it's early to discard wholly the concerns posed by these skeptics yet, if a rising global popularity of cryptocurrencies and growing confidence in their use is of any indication, one can safely assume that cryptocurrencies are not just here to stay but will only grow in relevance in the coming years. Given blockchain’s data privacy applications, many industries, such as fintech, healthcare, and others, are also adopting its use. Moreover, crypto is finding its place in the global financial system as well, with countries like El Salvador adopting Bitcoin as legal tender and others incorporating crypto in their national economic systems, presenting an optimistic outlook for crypto supporters and enthusiasts.
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